Has Worker Compensation Tracked Productivity?

The following is an excerpt from Economics21's new inequality primer, Income Inequality: Myths and Facts.

The debate over the minimum wage really gets to the heart

of one of the basic differences in how the Political Left and Right see the world. It is, in fact, one of the core misperceptions underlying the Left's economic prescriptions.

I read a recent New York Times op-ed describing why we need to raise the minimum wage to $10.10 an hour. Figure 9 presents the core of the argument. Productivity since 1973 has gone up 100 percent, according to the Bureau of Labor Statistics. When you adjust payroll survey wages for inflation using the CPI, it looks as if average wages have gone down about 7 percent. 

The core of the New York Times argument is: businesses have been making more and more money; workers have become more productive but are not sharing in the fruits of their labor; instead, greedy capitalists have expropriated it; something has to be done so that companies give workers the raise they have earned. This is not welfare, since businesses are unfairly keeping what workers have earned from them. The left repeats these claims over and over again. Productivity has gone up, but workers do not enjoy the fruits of their labor. So the government must step in. This would be a compelling argument—if only it were true.

This analysis makes an apples to oranges comparison. These figures come from different data sets that measure different things, using very different methodologies. What I find in "Productivity and Compensation: Growing Together" is exactly what many of the Federal Reserve Banks, Martin Feldstein, and even liberal economist Dean Baker have found. When researchers compare the numbers carefully they can make an apples to apples comparison. Such comparisons find pay and productivity track each other very closely.

One thing missing from Figure 9 is that the pay figure only counts about 60 percent of workers in the economy. Basically, it only measures hourly earners, not salaried employees. Also, there is something excluded from hourly wages: benefits. Figure 10, below, shows what happens when one includes total compensation, as well as the average hourly compensation of the entire economy. It shows that total compensation has not gone down, but actually risen 30 percent.

However, this adjusts for inflation using the Consumer Price Index. The CPI has a lot of problems, including formula issues. Indeed the CPI uses what econometricians and statisticians know to be a less accurate methodology when calculating inflation.

If analysts use a better measure of inflation, the Personal Consumption Expenditures Price Index, this eliminates some, but not all, of the bias in the inflation measurements. Using the PCE to calculate total compensation, as shown in Figure 11, finds average hourly compensation has increased 56 percent—very different from the 7 percent drop the Left cites. 

But still, even the PCE is not strictly comparable. The Bureau of Labor Statistics uses another measure of inflation to calculate productivity changes over time. The Bureau of Labor Statistics, quite sensibly, measures productivity inflation using changes in the costs of the goods a company sells.

If a person runs ACME widget factory and sells widgets in America, it really does not matter to that person how the price of oil imported from Saudi Arabia changes. That has no impact on their ability to pay employees wages or benefits. The only thing that matters, in terms of compensation decisions, is how much they can sell widgets for. The price of widgets determines the productivity of employees at this company. If people will pay more money for the widget, then effectively workers have become more productive. If people pay less for the widget, the value of their labor has gone down. Changes in prices of imported foreign goods really have no impact on the ability of companies to compensate their employees. 

The BLS calculates inflation in its productivity figures by only looking at changes in the prices of goods that American workers produce. These prices differ from the price of goods Americans consume because of imports and exports.

BLS does this with an inflation measure called the Implicit Price Deflator for Non-Farm Business. Basically, it only looks at the changes in goods produced by non-farm business in the United States. As shown in Figure 12, total compensation, on an apples to apples comparison, has increased 77 percent over the past 40 years. This is, again, very different from the very first slide which showed wages falling 7 percent.

Even this remaining 23 percent gap is exaggerated, for two reasons. The government productivity is mismeasured and overstated, because BLS is doing an incomplete job accounting for the prices of imported goods that have been used in production. Consider a widget factory that starts using cheaper inputs from China. The BLS does not capture the full cost-savings to employers. It appears to BLS that factories are producing more widgets at lower cost. This looks like increased productivity. However, the gains are coming from trade and the lower price foreign goods, not worker productivity. This may account for about half of the remaining 23 point gap you see in Figure 12.

Another factor that has changed is depreciation. Today, businesses use a lot more computers and robots in production than 40 years ago. Buildings last for a while, while depreciation rates on buildings have not changed much. If a company built a manufacturing factory 20 years ago, that business could still use the same building and some of the heavy machinery today. What about computers? Would anyone want to use a 1994 computer to run a manufacturing facility? Computers and software depreciate. They do not last as long and they become obsolete faster. Even if a manufacturer had a 1994 computer in perfect condition, he still would not want to use it. 

Depreciation rates have increased. But BLS measures productivity on the basis of gross productivity. They do not factor in changes in depreciation rates, only how many gross widgets get produced. If a company has to replace computers and machines every five years instead of every eight years, this does not affect gross productivity. However, when it comes to measure earned income, whether of investors, business owners, or workers, what matters is individual net productivity: what remains after the machinery and equipment used up in the process get replaced. Depending on how it is measured, depreciation accounts for another five points or so of the remaining gap between productivity and compensation. 

So even the much smaller gap remaining in Figure 12 is exaggerated. Workers are indeed enjoying the fruits of their labor. 

This is both good and bad news. Good because it means companies are not exploiting their workers. Bad because it means there are no easy solutions. If the minimum wage could simply be raised to $10 an hour, and people could just tell businesses, "You are making more, you have tons of profits, just pay more out of your profits," this would be easy to fix by changing the law. But that is not the world we live in.

In the actual world, the reason minimum wage workers do not earn much is that workers in those jobs have not become that much more productive over time. The data goes back to 1987, and if productivity in the fast food sector is examined, pay and productivity track almost one to one. Both have gone up about ten percent in inflation adjusted terms. If businesses have to pay employees $10 an hour when employees do not produce that value, they will spend a lot of time and money investing in labor-saving technologies and finding ways to make due with fewer workers.

The actual way to increase living standards is by increasing productivity. Things such as charter schools increase their student's productivity and economic mobility. There are studies about people who went to charter schools, in the mid-and late-1990s, and who are now in their 30s. Such people are experiencing measurably higher incomes than their peers who did not attend charter schools. The government should pursue these sorts of solutions. Make workers more productive, and competitive forces in the economy will force business to pay more. It would be nice if we could just raise the minimum wage and give workers more—the world, alas, does not work that way.

Taken from the Economics21 issue brief, Income Inequality: Myths and Facts.

James Sherk is a senior policy analyst in labor economics at The Heritage Foundation. You can follow him on Twitter here.

Interested in real economic insights? Want to stay ahead of the competition? Each weekday morning, e21 delivers a short email that includes e21 exclusive commentaries and the latest market news and updates from Washington. Sign up for the e21 Morning eBrief.